The future of the retrofit business

A retrofit is the application of technology, engineering, and capital to real estate to improve building performance and value. The supplier is a project developer or perhaps an ESCO (let’s call this category of supplier an energy efficiency developer), and the customer is the building owner or in some cases the tenant. The fundamental interaction involves the supplier providing the customer with energy efficiency measures and the customer paying the supplier for the value of future energy savings.

Today, energy efficiency is a high margin, low volume business. Transactions are slow and complicated, and they take a lot of work to develop and sell. A deal could take many months to run feasibility and engineering studies and conduct negotiations before actual physical construction work on the retrofit project even begins. Often, building audits and engineering analyses appear very costly to building owners and can sometimes prove complicated, further slowing the process.

Because today’s retrofits take so much work and have high risk of non-completion, developers demand high returns from the project to cover their time and initial expenses, which makes the project very expensive from the customer’s perspective. Further complicating the situation, the capital needed to fund retrofits tends to be costly, as capital providers still struggle to price the risk inherent in retrofit projects.

From a building owner’s perspective – and again the building owner is the customer in this transaction – a retrofit is an expensive, complicated product that takes a lot of time and effort to complete successfully.

Even though the building owner often doesn’t have to come out of pocket to pay for this product, the retrofit is not free. The building owner knows they will have to cede a significant portion of the value of future energy savings to the supplier to compensate the developer for the time and effort and risk they put into the project, but at today’s economics, many buildings owners don’t think it’s a good deal. The future value paid to the developer also doesn’t capture the significant amount of time that the building owner will have to put into upfront negotiations and related closing tasks. Building owners aren’t jumping at the current energy efficiency product offerings because in many cases they don’t meet the owner’s needs as a customer.

What will have to change in order to make energy efficiency easy? What will increase the number of retrofit projects in the market and help achieve the scale that the energy efficiency market has the potential to deliver?

“Without real estate, structurally, there is no retrofit project. By definition, a retrofit must be “of a building.” Therefore, retrofits must be useful to real estate owners and operators, ON THEIR TERMS.”

Suppliers will have to cater to building owners, the customer, the party with the most leverage in the transaction, in order to grow volume and scale the market. How will they do this?

First, energy efficiency suppliers will have to make it far easier for customers (building owners) to purchase the product. This means the product will have to get better. Energy audits will be easier and cheaper and likely entirely funded by the supplier. Time to complete both the deal and construction will likely be dramatically shorter. Service and support such as post-retrofit continuous commissioning will likely become standard.

Marketing of the product will also improve. Benefits of the retrofit will be explained more comprehensibly, in language that is native and applicable to the customer. By extension, the benefits will also need to be explained to the many specific sub-departments that have a say in a building’s purchasing decisions, from the facilities guys to the finance department. Accounting is different than legal is different than asset management is different than tenant services, and the best energy efficiency suppliers will understand these differences and cater to them. Data will be used to quantify and support claims, with specific reference to client building types, local market dynamics, and other building specific drivers.

These changes will also drive improved branding for retrofitted buildings, which will allow building owners to market the benefit of the retrofits to current and future tenants in order to increase occupancy and rental rates. Eventually a retrofitted building, and all the high performance attributes that go with it, will be a “must have” for real estate.

Second, margins for “off-the-shelf” retrofits will compress. Building owners are smart economic actors. It’s not a stretch for them to realize that if someone else is willing to invest significant capital in reducing energy costs in their building and get paid purely by the savings, those returns must be attractive relative to the risks. This is one of the reasons why the best-capitalized real estate leaders all currently say they self-fund efficiency (Vornado, Related, and Tishman Speyer come to mind).

To say it another way, standard retrofits will get cheaper for building owners. A larger portion of the savings will accrue to building owners, and retrofit suppliers will take a smaller cut. On the surface, this margin compression appears to be negative for retrofit suppliers. The reality is that the corresponding increase in volume will be the driver of scale and maturity for the industry. A few large retrofit service providers will emerge who have national scale and scope to do low-margin retrofits and still generate huge profits despite moderation in margins. The cost of capital supporting the retrofit providers will decrease, allowing further savings to be passed to the customer. Efficiencies of scale and best practices will drive costs even lower still.

Lower margins in standard retrofit projects will also open the possibility for higher-margin specialty retrofit products, like deep retrofits and eventually zero net energy retrofits. Developers and building owners utilizing cutting-edge technology to re-retrofit will also maintain high margins by leading the industry and providing valuable produces to building owners.

The bottom line is that the energy efficiency business at scale will look dramatically different than it looks today. Suppliers of building energy efficiency would do well to keep that in mind, as this transition is already under way.